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In the forex market, investors have an array of trading instruments at their disposal, with Contracts for Difference (CFDs) and futures contracts being two options. While both offer opportunities for speculation and hedging, they possess distinct characteristics that can significantly impact trading strategies and risk exposure.
In this comprehensive article, we delve into the essential dissimilarities between CFDs and futures.
What are CFDs?
CFDs are financial derivatives that allow traders to speculate on the price movements of various assets (currency pairs) without owning the underlying asset itself. When trading CFDs, traders enter into a contract with a broker, and the difference between the asset’s price at the beginning and end of the contract is settled as cash.
What are futures?
Futures contracts are standardized agreements that oblige the parties involved to trade a specific currency pair at a predetermined price on a specified future date.
Unlike CFDs, upon a Future contract’s expiration, the parties are required to physically exchange the agreed-upon currency amounts at the predetermined exchange rate.
Differences between CFDs vs futures
Contract type and size
CFDs: CFDs are flexible contracts that allow traders to speculate on the price movements of various financial instruments, such as stocks, indices, currencies, commodities, and cryptocurrencies. The contract size in CFDs is not fixed and can be as small as one-tenth of the underlying asset’s size. This enables traders to enter positions with smaller capital requirements and trade fractional units of expensive assets like gold or tech stocks. This flexibility allows for more precise position sizing and reduces the capital requirements for entering trades compared to futures contracts, which have fixed contract sizes. However, traders should be cautious about the increased exposure to market fluctuations and the potential for significant losses due to leverage.
Futures: Futures contracts are standardized agreements with specific terms, including the quantity of the underlying asset. Each futures contract has a fixed contract size determined by the exchange.
Expiry
CFDs: CFDs do not have a fixed expiry date, allowing traders to hold positions for as long as they wish. This flexibility is advantageous for those who prefer long-term trading or do not want to be forced to roll over positions regularly. However, it’s important to note that this flexibility comes with the risk of overnight financing charges. Holding CFD positions overnight may result in additional costs, as brokers often charge fees for the privilege of holding positions beyond the trading day.
Futures: Futures contracts have fixed expiry dates, usually falling on a monthly or quarterly basis. As the expiry date approaches, traders need to decide whether to close their positions or roll them over to the next contract period.
Costs/fees
CFDs: The main costs associated with CFD trading are the spread (the difference between the bid and ask prices offered by the broker) and overnight financing charges if positions are held overnight. Some brokers may also charge commissions on CFD trades.
Futures: Futures trading generally involves lower costs compared to CFDs. Traders typically pay lower commission fees because they are trading on a centralized exchange. Additionally, futures contracts often have narrower bid-ask spreads, reducing the cost of entering and exiting positions. However, it’s important to note that futures trading carries the risk of price volatility, and traders can incur significant losses if market movements are not in their favor.
Regulation
CFDs: CFDs are usually offered by over-the-counter brokers, and the regulatory environment can vary depending on the country or region in which the broker operates. Some jurisdictions have stricter regulations, while others may have limited oversight, potentially exposing traders to more risks.
Futures: Futures contracts are highly regulated financial instruments. They are traded on recognized exchanges, such as the Chicago Mercantile Exchange (CME) in the United States, under the supervision of regulatory authorities like the Commodity futures Trading Commission (CFTC). This regulatory oversight provides traders with increased transparency and protection against fraudulent practices. It is also important to consider that regulatory changes or interventions can also impact the trading environment. Traders should be aware that regulatory decisions could lead to sudden shifts in market conditions or rules, potentially affecting trading strategies and outcomes.
Counterparty risk
CFDs: When trading CFDs, traders are exposed to the counterparty risk of the broker. If the broker fails to fulfill its obligations due to financial difficulties or bankruptcy, the trader may face losses.
Futures: Futures contracts are cleared by a central counterparty (clearing house), which acts as an intermediary between the buyer and the seller. The clearing house keeps the performance of the contract, significantly reducing counterparty risk. If one party defaults, the clearing house steps in to ensure the trade’s completion.
Market hours
CFDs: CFD trading is not limited to specific exchange hours since it occurs over the counter through brokers. As a result, CFD markets are usually open 24 hours a day, five days a week, reflecting the global nature of the financial markets.
Futures: Futures contracts are subject to specific trading hours based on the exchange they are listed on. Traders can only execute trades during the exchange’s designated trading sessions.
Settlement
CFDs: With CFDs, traders do not take physical possession of the underlying asset. Instead, gains or losses are calculated based on the difference between the contract’s opening and closing prices.
Futures: Futures contracts can be physically settled, where the delivery of the underlying asset occurs at expiry (e.g., commodities like crude oil or agricultural products). However, most traders close their positions before expiry and opt for cash settlement, where the difference between the contract’s settlement price and the initial trade price is settled in cash.
Asset ownership
CFDs: CFD trading allows traders to speculate on price movements without owning the underlying asset. The trader holds a contractual position with the broker but does not become a shareholder or have any ownership rights.
Futures: Similar to CFDs, futures trading does not grant ownership of the underlying asset until the contract is physically settled. Most futures traders focus on trading contracts to gain from price fluctuations without taking possession of the physical asset.
CFD vs futures: Which is more suitable?
Both CFDs and futures have their benefits and risks. CFDs offer a wide range of assets but come with the risk of exposure to multiple markets. But traders should be cautious not to spread themselves too thin or underestimate the complexities of the different markets they are trading, as inadequate knowledge can increase the risk of making poor investment decisions.
Futures provide exposure to specific commodities and products, but require careful consideration of market trends, as failing to anticipate shifts in supply and demand dynamics can lead to unexpected losses. Ultimately, the choice between CFDs and futures depends on individual trading objectives, risk tolerance, and the specific assets one wishes to trade.
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Disclaimer:
- The material published on this website is general information only and does not take into account your objectives, financial situation or needs .Trading FX and CFDs on margin involves a high level of risk and may not be suitable for all investors. As margin FX/CFDs are highly leveraged products, your gains and losses are magnified, and you could lose substantially more than your initial deposit. Investing in margin FX/CFDs does not give you any entitlements or rights to the underlying assets (e.g. the right to receive dividend payments).
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